Section 3
Function 3: Investment Products, Recommendations & Records
Asset-backed securities and CMOs
47 min read
· Lesson 8 of 19
About This Lesson
Chapter 12 promised the CMO story; here it is. Securitization takes pools of loans, mortgages, auto loans, credit cards, and turns their cash flows into tradeable securities; CMOs go one step further and slice mortgage cash flows into tranches with different lives and different risk. The exam's favorite angle is the counterintuitive one: which tranche wins and which loses when prepayments speed up or slow down.
What you'll cover
- the securitization framework (originator, SPV, servicer, credit enhancement) and the ABS asset types, amortizing versus nonamortizing
- CDOs, then CMO tranche mechanics: sequential pay, PAC, TAC, Z-tranche, companion, IO and PO strips
- the risk and tax picture: not government-backed, fully taxable, and the prepayment/extension trade running through everything
This is the eighth chapter of the products module.
In this chapter
47 min · 13 concept checks
Section 1 of 4
~10 min · 3 concept checks
ABS Framework & Types
Asset-Backed Securities: The Securitization Framework
Securitization is the machine behind this whole chapter: pool up assets that generate cash flows, then sell securities backed by those flows. Illiquid loans become tradeable paper, and the lender's capital comes back to make new loans. Four parts, in order:
- Originator: A bank or lender originates loans (mortgages, auto loans, credit cards, student loans) and sells them to a special purpose vehicle (SPV)
- Special purpose vehicle (SPV): A bankruptcy-remote legal entity that holds the pool of assets. Its sole purpose is to issue securities backed by those assets. Because it is separate from the originator, the ABS investors are protected if the originator goes bankrupt
- Servicer: Collects payments from the underlying borrowers and passes them through to the SPV (and ultimately to ABS investors)
- Credit enhancement: Mechanisms to improve the credit quality of the issued securities above the underlying pool. Examples: overcollateralization, reserve accounts, senior/subordinate structuring
What gets securitized: mortgage loans above all (the largest category), then auto loans, credit card receivables, student loans, equipment leases, and commercial mortgages (CMBS).
Asset-Backed Securities: Types and Distinguishing Features
The exam tests ABS by their underlying assets, and one classification question dominates: does the underlying loan amortize on a schedule, or revolve forever?
Common ABS Underlying Asset Types
| Underlying Asset | Amortizing or Nonamortizing | Notes |
|---|---|---|
| Auto loans | Amortizing | Fixed monthly payments of principal and interest until loan maturity. |
| Student loans | Amortizing | Scheduled repayment over set term; some flexibility from federal program structures. |
| Credit card receivables | Nonamortizing | Revolving balances with no fixed maturity; principal cycles continuously. |
| Mortgages | Amortizing | Backing for mortgage-backed securities (MBS), typically classified separately from ABS. |
ABS terminology trap:
Real estate is NOT classified as ABS backing. Mortgages do back securities,
but those securities are mortgage-backed securities (MBS), a separate
category from ABS. The exam tests whether candidates recognize that "ABS"
does not include real-estate-backed instruments — they get their own
MBS / CMO terminology.
Amortizing vs. Nonamortizing
Amortizing
Underlying loans repay principal on a fixed schedule. Auto loans, student loans, mortgages. Cash flow to ABS investors includes both principal and interest from each scheduled payment.
Nonamortizing
Underlying loans are revolving credit lines without fixed maturity. Credit card receivables are the standard example. Principal cycles continuously as borrowers repay and re-borrow.
Collateralized Debt Obligations (CDOs)
A CDO is the same tranche idea pointed at a wider target. Where a CMO draws only on mortgages, a CDO pools other debt:
CDO Underlying Collateral
- Corporate bonds: Investment-grade or high-yield corporate debt.
- Bank loans: Leveraged loans and middle-market credit facilities.
- Other ABS: Tranches from auto loan ABS, credit card ABS, or student loan ABS.
- Mortgages: Sometimes included alongside other debt categories.
Cash flows run through tranches exactly as in a CMO: senior classes get paid first and carry less credit risk; junior classes wait, absorb the first losses, and collect extra yield for it.
Regulatory note: CDOs sat at the center of the 2008 crisis, when structures stuffed with subprime mortgages took severe losses, and the reform that followed tightened transparency, ratings, and disclosure. They remain legitimate, tested instruments; the history is context, not disqualification.
Concept Check
What is the primary purpose of creating a special purpose vehicle (SPV) in the securitization process?
The SPV (also called a special purpose entity) is a bankruptcy-remote legal entity that holds the pool of assets separately from the originating institution. If the originator goes bankrupt, creditors cannot reach the assets held in the SPV — they are legally isolated. This structural protection is what allows ABS to receive high credit ratings independent of the originator's financial condition. The assets are sold to the SPV, not merely pledged, so they leave the originator's balance sheet.
Concept Check
A structured instrument known as an asset-backed security (ABS) would NOT be backed by which of the following underlying asset categories?
Asset-backed securities (ABS) are NOT backed by real estate. Real estate-backed securities are classified as mortgage-backed securities (MBS), a separate category with distinct terminology and structure including collateralized mortgage obligations (CMOs). ABS underlying assets include auto loans, credit card receivables, student loans, and other consumer or commercial receivables. The exam tests whether candidates can correctly distinguish ABS from MBS — a confusion that arises because both involve securitization of underlying loans. If loans are collateralized by real property, the security is MBS or CMO, not ABS.
Concept Check
Asset-backed securities can be structured as either amortizing or nonamortizing instruments. Which of the following underlying asset types would form the basis for a NONAMORTIZING ABS?
Credit card receivables form nonamortizing ABS because the underlying borrowing is revolving — cardholders make minimum payments and continue spending, with no fixed maturity or scheduled principal repayment. The principal balance cycles continuously as borrowers repay and re-borrow. Auto loans, mortgages, and student loans are amortizing because each scheduled payment includes both principal and interest with a defined amortization schedule that fully retires the principal balance by maturity. The amortizing-versus-nonamortizing distinction is fundamental to ABS analysis.
Section 2 of 4
~12 min · 3 concept checks
CMO Structure & Tranches
Collateralized Mortgage Obligations (CMOs)
A CMO is an MBS where the pass-through cash flows from a pool of mortgages are divided into separate classes called tranches, each with different maturities and risk profiles. CMOs were created specifically to address the prepayment risk problem of plain pass-through certificates — by redirecting cash flows, they allow investors to choose their preferred risk/maturity exposure.
Why tranches exist: A plain MBS pass-through distributes all principal and interest pro-rata to all investors. As prepayments occur, all investors receive principal back at the same rate. A CMO reorders who gets principal first, creating tranches with different effective maturities.
Standard tranches
Protected tranches
High-risk / speculative
Sequential pay (A/B/C)
Principal flows to A first until retired, then B, then C. Creates short, medium, and long effective maturities from one pool.
Specific maturity window
Z-tranche (accrual bond)
Receives no cash until all prior tranches retire. Interest accrues and compounds, then large lump-sum payment.
Zero-coupon-like
PAC (planned amortization)
Scheduled principal within a prepayment band. Companion absorbs excess/shortfall. Most prepayment-protected tranche.
Most stable cash flow
Companion (support)
Absorbs the variability PAC avoids. Extra principal when prepayments high, less when slow. Highest prepayment risk.
Highest risk in CMO
Interest-only (IO) strip
Receives only interest. Value rises when rates rise (slower prepayments = more interest). Opposite of most bonds.
Inverse rate behavior
Principal-only (PO) strip
Receives only principal at deep discount. Value rises when rates fall (faster prepayments return principal sooner).
Rate-sensitive
CMO Structure: Tranches and Risk Distribution
A CMO takes a mortgage pool and carves the cash flows into classes (tranches) that receive principal in a strict sequence, which lets investors with different time horizons buy exactly the slice of the mortgage market they want:
Standard Plain-Vanilla CMO Tranche Sequence
All tranches typically receive interest payments simultaneously. However,
principal payments flow to one tranche at a time:
Tranche A receives ALL principal payments first until fully paid down.
Tranche B begins receiving principal only after Tranche A is fully retired.
Tranche C begins receiving principal after Tranche B is fully retired.
This sequential principal payment creates different effective lives for different tranches — short-life for Tranche A, longer for B and C.
Tranche A receives ALL principal payments first until fully paid down.
Tranche B begins receiving principal only after Tranche A is fully retired.
Tranche C begins receiving principal after Tranche B is fully retired.
This sequential principal payment creates different effective lives for different tranches — short-life for Tranche A, longer for B and C.
Specialized CMO Tranche Classes
PAC Tranche
Planned Amortization Class: Most stable cash flow profile. Prepayment risk shifted to companion tranches. Suited to investors needing predictable principal repayment timing.
TAC Tranche
Targeted Amortization Class: Stable timing under prepayment scenarios but less protection than a PAC. Mid-tier predictability.
PO Tranche
Principal-Only: Receives only principal payments, no interest. Bought at deep discount. Benefits from fast prepayment (early principal returns).
IO Tranche
Interest-Only: Receives only interest payments, no principal. Suffers from fast prepayment (interest stream shrinks faster than expected).
Z-Tranche
Zero (accrual) tranche: Receives no payments until all earlier tranches are retired. Interest accrues until then. Most volatile cash flow timing of any standard CMO class.
Z-tranche unsuitable for
known time horizons. A Z-tranche’s payment timing depends
entirely on prepayment patterns of all earlier tranches — timing
cannot be predicted with any confidence. An investor needing funds in a
specific timeframe should not be in a Z-tranche.
Interactive: CMO Tranche Waterfall
Prepayment speed:
Period 1 of 6
Tranche A
Sequential — first to receive principal
$100M
Receiving principal
Tranche B
Sequential — second priority
$80M
Interest only — waiting
Tranche C
Sequential — third priority
$60M
Interest only — waiting
Z-tranche (accrual bond)
Last — no cash until A, B, C retire
$50M
Accruing interest (no cash)
Period 1: All tranches active. Principal flows first to Tranche A. B and C receive interest only. Z accrues — no cash yet.
Concept Check
Which of the following CMO tranches receives NO cash payments — neither interest nor principal — until all other tranches in the structure have been fully retired?
The Z-tranche (accrual bond or Z-bond) receives no cash payments until all prior tranches are retired. During this time, interest accrues and compounds on the outstanding Z-tranche balance. Once prior tranches are paid off, the Z-tranche receives all remaining principal plus its accumulated interest. This makes it similar in behavior to a zero-coupon bond — a single large payment at the end rather than periodic cash flows.
Concept Check
A Z-tranche of a collateralized mortgage obligation (CMO) would be considered UNSUITABLE for an investor whose primary investment consideration is
A Z-tranche has unpredictable payment timing because all interest and principal payments are deferred until earlier CMO tranches are fully retired. The timing depends entirely on prepayment patterns of the underlying mortgages affecting the earlier tranches — a sequence that cannot be predicted with confidence. An investor needing funds at a specific known future date faces serious mismatch risk if the Z-tranche pays earlier or later than expected. Z-tranches actually fit investors seeking longer-duration exposure and accrued interest profiles. A known time horizon is not among them.
Concept Check
Which of the following statements about Collateralized Mortgage Obligations (CMOs) is most accurate?
CMOs are corporate instruments, not direct U.S. government obligations. Although the underlying mortgage pools backing a CMO may include agency-issued mortgages (Fannie Mae, Ginnie Mae, Freddie Mac), the CMO itself is structured by a private financial institution. The U.S. government does not guarantee CMO payments. This distinguishes CMOs from Treasury securities and direct agency debt, which carry explicit (Treasury) or implicit (agency) federal backing. CMOs are also not municipal securities; municipal bonds are issued by state category entirely.
Section 3 of 4
~12 min · 5 concept checks
Tranche Variants: PAC, Companion, IO/PO
PAC Bonds vs. Companion Tranches: The Risk Trade-Off
The PAC/companion structure is the most tested CMO configuration on the Series 7 because it involves a clear risk transfer between two investor classes.
PAC (planned amortization class)
Lowest prepayment risk — most predictable
Scheduled to receive principal at a predetermined rate within a prepayment band
Companion tranche absorbs excess prepayments and shortfalls
Lower yield than companion — investors pay for stability
Protection breaks down if prepayments exceed the defined band
Companion (support) tranche
Highest prepayment risk — most variable
Receives excess principal when prepayments are high (prepayment risk)
Receives little principal when prepayments are slow (extension risk)
Higher yield than PAC — compensation for absorbing the risk
Most volatile effective maturity of any CMO tranche
Key insight: A CMO does not eliminate prepayment risk —
it redistributes it. The total prepayment risk in the pool is the same; the PAC/companion
structure just determines who bears it. Every dollar of stability given to PAC investors
comes at the expense of greater volatility for companion tranche investors.
IO and PO Strips: The Counterintuitive Rate Relationships
IO and PO strips move opposite to each other, and the IO moves opposite to your bond instincts:
IO (interest-only) strip:
• Rates FALL: homeowners prepay faster, less interest gets paid over the pool's life, and the IO loses value. The opposite of most bonds.
• Rates RISE: prepayments slow, the interest stream runs longer, and the IO gains value.
PO (principal-only) strip:
• Rates FALL: prepayments accelerate, the principal you bought at a discount comes back sooner, IRR rises, the PO gains value. Bond-like behavior.
• Rates RISE: prepayments slow, principal is delayed, the PO loses value.
The exam trap: an investor holds an IO strip and rates fall sharply. Most candidates expect a gain, the way a bond would gain. The IO loses, because the prepayments are eating its interest stream.
IO and PO strips move opposite to each other, and the IO moves opposite to your bond instincts:
IO (interest-only) strip:
• Rates FALL: homeowners prepay faster, less interest gets paid over the pool's life, and the IO loses value. The opposite of most bonds.
• Rates RISE: prepayments slow, the interest stream runs longer, and the IO gains value.
PO (principal-only) strip:
• Rates FALL: prepayments accelerate, the principal you bought at a discount comes back sooner, IRR rises, the PO gains value. Bond-like behavior.
• Rates RISE: prepayments slow, principal is delayed, the PO loses value.
The exam trap: an investor holds an IO strip and rates fall sharply. Most candidates expect a gain, the way a bond would gain. The IO loses, because the prepayments are eating its interest stream.
Concept Check
An investor holds the companion (support) tranche of a CMO. Interest rates fall sharply and mortgage prepayments accelerate well above expected levels. How is the companion tranche investor most directly affected?
The companion tranche is designed to absorb excess prepayments, protecting the PAC tranche. When prepayments accelerate, the companion receives the extra principal — shortening its effective maturity. The investor must then reinvest at the now-lower rates, creating reinvestment (prepayment) risk. This is the trade-off: the companion absorbs volatility to give the PAC stability, and receives a higher yield as compensation.
Concept Check
Which CMO tranche type provides the most predictable cash flows by having a companion tranche absorb excess prepayments and shortfalls?
PAC tranches are specifically designed for prepayment stability. They have a scheduled principal payment window that is maintained across a band of prepayment speeds. Any excess prepayments above the band go to the companion (support) tranche first, and any shortfalls also come from the companion. As long as prepayments stay within the defined band, PAC investors receive highly predictable cash flows. This predictability comes at a cost — lower yield relative to companions — as the companion investors bear the variability.
Concept Check
Among CMO tranche types, which classification is structured to provide investors with the MOST stable principal repayment timing?
Planned Amortization Class (PAC) tranches provide the most stable principal repayment timing among standard CMO tranche types. PAC structures use companion (or support) tranches that absorb prepayment risk, leaving the PAC investor with predictable principal cash flows across a wide range of prepayment scenarios. TAC tranches offer some prepayment protection but less than PACs, sitting at mid-tier predictability. Z-tranches are at the opposite extreme. PO tranches receive only principal but with timing entirely dependent on prepayment patterns.
Concept Check
An investor purchases an interest-only (IO) mortgage strip. If interest rates rise significantly, the value of the IO strip will most likely:
IO strips have an unusual relationship with interest rates: when rates rise, prepayments slow and the pool continues paying interest for longer, increasing the total interest the IO receives. This causes the IO to gain value when rates rise — the opposite of most fixed income instruments. When rates fall, homeowners refinance (prepay), cutting off the interest stream early and causing the IO to lose value. This counterintuitive behavior is a classic Series 7 exam trap.
Concept Check
A principal-only (PO) mortgage strip is purchased at a deep discount. Interest rates subsequently fall sharply. How is the PO strip investor most directly affected?
PO strips receive only principal payments. Purchased at a discount, the investor's return depends on receiving that principal as quickly as possible. When rates fall, homeowners refinance and prepay their mortgages faster, accelerating the principal return. Receiving discounted principal sooner raises the IRR significantly. This makes PO strips positively correlated with falling rates — they gain value as rates fall, similar to a regular bond but more extreme. The inverse is true for IO strips.
Section 4 of 4
~8 min · 2 concept checks
Risks, Taxation & Exam Traps
CMO Risks, Backing, and Taxation
CMOs Are NOT Government-Backed
The misconception writes itself: mortgages back CMOs, the government backs mortgages, so the government must back CMOs. It does not. A CMO is a corporate instrument. The pool inside may hold agency-issued mortgages from Fannie, Ginnie, or Freddie, but the issuer is typically a private financial institution, and the U.S. government guarantees nothing about the CMO's payments.
Tax Treatment: Fully Taxable at All Levels
Interest paid on CMOs is fully taxable at all three levels:
• Federal tax
• State tax
• Local tax
This contrasts sharply with U.S. Treasury securities (state and local exempt) and municipal bonds (federal exempt, often state exempt for in-state investors). The full taxability is one reason CMOs offer higher yields than Treasuries.
• Federal tax
• State tax
• Local tax
This contrasts sharply with U.S. Treasury securities (state and local exempt) and municipal bonds (federal exempt, often state exempt for in-state investors). The full taxability is one reason CMOs offer higher yields than Treasuries.
CMO Risk Profile Summary
- Not US-government backed: Corporate instruments, not Treasury or agency direct obligations.
- Backed by mortgage pools: Cash flows depend on the underlying mortgages’ performance.
- Yield more than Treasuries: Compensates for credit risk, prepayment risk, and full taxability.
- Subject to prepayment risk: Faster-than-expected prepayments accelerate principal return; slower prepayments extend duration. Different tranches have different prepayment exposure.
- Subject to extension risk: The opposite of prepayment risk — in rising-rate environments, prepayments slow and the security’s effective life extends beyond expectations.
CMO Exam Traps: Four Questions, Four Clean Answers
Q: Which CMO tranche has the most prepayment risk?
A: the companion (support) tranche; it absorbs all the excess prepayments.
Q: Which CMO tranche is most like a zero-coupon bond?
A: the Z-tranche; no cash until every prior tranche retires, with interest accruing and compounding in the meantime.
Q: Does a CMO eliminate prepayment risk?
A: No. It redistributes the risk among tranches; the pool's total risk never changes.
Q: What happens to an IO strip when rates rise?
A: It gains value; slower prepayments stretch the interest payments over a longer life. Counterintuitive, and directly tested.
Q: Which CMO tranche has the most prepayment risk?
A: the companion (support) tranche; it absorbs all the excess prepayments.
Q: Which CMO tranche is most like a zero-coupon bond?
A: the Z-tranche; no cash until every prior tranche retires, with interest accruing and compounding in the meantime.
Q: Does a CMO eliminate prepayment risk?
A: No. It redistributes the risk among tranches; the pool's total risk never changes.
Q: What happens to an IO strip when rates rise?
A: It gains value; slower prepayments stretch the interest payments over a longer life. Counterintuitive, and directly tested.
ABS and CMO Exam Traps — Consolidated
Twelve ABS and CMO traps with exam history. One pass before test day; each line settles a recurring question:
1. ABS are NOT backed by real estate. Real estate-backed securities are mortgage-backed securities (MBS), a separate category. ABS underlying assets include auto loans, credit cards, student loans.
2. Credit card debt is the standard nonamortizing ABS example. Auto loans, student loans, and mortgages are amortizing. Credit cards revolve continuously without scheduled principal repayment.
3. CMOs are corporate instruments, NOT US-government backed. Even when underlying mortgages are agency-issued, the CMO itself is a private securitization. Treasury and direct agency debt are different categories.
4. CMO interest is fully taxable at federal, state, AND local levels. No exemptions. Contrasts with Treasuries (state and local exempt) and munis (federal exempt).
5. CMOs yield more than Treasuries. Compensates for credit risk, prepayment risk, and full taxability.
6. Z-tranche unsuitable for investors with known time horizons. No payments until all earlier tranches retire. Timing depends entirely on prepayment patterns and is unpredictable.
7. PAC tranches have the most stable cash flow. Companion tranches absorb prepayment risk. PACs suit investors needing predictable principal repayment.
8. PO tranches benefit from fast prepayment. Bought at deep discount; receive principal sooner than expected if prepayments accelerate. IO tranches suffer from fast prepayment for the opposite reason.
9. All CMO tranches receive interest simultaneously. Principal payments flow to one tranche at a time in plain-vanilla structures.
10. CDOs are backed by debt instruments other than just mortgages. Corporate bonds, bank loans, other ABS tranches. Tranche structure similar to CMOs.
11. Senior tranches in any structured product bear lower credit risk. Receive payments first; junior tranches absorb losses first.
12. CMOs and CDOs are subject to both prepayment risk AND extension risk. Faster-than-expected prepayment shortens duration; slower-than-expected prepayment extends it.
Twelve ABS and CMO traps with exam history. One pass before test day; each line settles a recurring question:
1. ABS are NOT backed by real estate. Real estate-backed securities are mortgage-backed securities (MBS), a separate category. ABS underlying assets include auto loans, credit cards, student loans.
2. Credit card debt is the standard nonamortizing ABS example. Auto loans, student loans, and mortgages are amortizing. Credit cards revolve continuously without scheduled principal repayment.
3. CMOs are corporate instruments, NOT US-government backed. Even when underlying mortgages are agency-issued, the CMO itself is a private securitization. Treasury and direct agency debt are different categories.
4. CMO interest is fully taxable at federal, state, AND local levels. No exemptions. Contrasts with Treasuries (state and local exempt) and munis (federal exempt).
5. CMOs yield more than Treasuries. Compensates for credit risk, prepayment risk, and full taxability.
6. Z-tranche unsuitable for investors with known time horizons. No payments until all earlier tranches retire. Timing depends entirely on prepayment patterns and is unpredictable.
7. PAC tranches have the most stable cash flow. Companion tranches absorb prepayment risk. PACs suit investors needing predictable principal repayment.
8. PO tranches benefit from fast prepayment. Bought at deep discount; receive principal sooner than expected if prepayments accelerate. IO tranches suffer from fast prepayment for the opposite reason.
9. All CMO tranches receive interest simultaneously. Principal payments flow to one tranche at a time in plain-vanilla structures.
10. CDOs are backed by debt instruments other than just mortgages. Corporate bonds, bank loans, other ABS tranches. Tranche structure similar to CMOs.
11. Senior tranches in any structured product bear lower credit risk. Receive payments first; junior tranches absorb losses first.
12. CMOs and CDOs are subject to both prepayment risk AND extension risk. Faster-than-expected prepayment shortens duration; slower-than-expected prepayment extends it.
Concept Check
Interest paid on CMOs to investors is subject to taxation at which level or levels of government?
CMO interest is fully taxable at federal, state, and local levels. No exemption applies at any government level. This contrasts with U.S. Treasury securities, where interest is exempt from state and local tax (federal taxable), and with municipal bonds, where interest is exempt from federal tax (and often from state tax for in-state investors). The full taxability of CMO interest is one of the reasons CMOs offer higher yields than comparable-duration Treasury securities — the higher yield compensates for the worse tax treatment along with credit and prepayment risks.
Concept Check
Compared to U.S. Treasury securities of similar duration, CMOs typically offer
CMOs typically yield more than Treasury securities of similar duration. The higher yield compensates investors for several risks and disadvantages absent from Treasuries: credit risk (CMOs are corporate instruments without Treasury backing), prepayment risk (timing of principal returns is unpredictable), and full taxability at all government levels (Treasuries are state and local exempt). CMOs do NOT carry direct U.S. government backing, ruling out the lower-yield distractor. Yields are not identical because the risk profiles differ substantially. Tax-equivalent comparisons are relevant for muni-vs-taxable analysis, not CMO-vs-Treasury.
Summary
Exam Essentials — high-yield review
Chapter Summary
Ch 15 Exam Essentials — Asset-Backed Securities and CMOs
- CMO tranche hierarchy: Sequential tranches receive principal in order (A then B then C). Z-tranche receives no cash until all others retire — interest accrues. PAC tranche has most stable cash flows. Companion tranche absorbs variability.
- Prepayment vs. extension risk: Prepayment risk: rates fall, homeowners refi, principal returned early, reinvest at lower rates (harms regular MBS and companion tranches). Extension risk: rates rise, prepayments slow, effective maturity lengthens.
- IO/PO strips: IO gains value when rates RISE (slower prepayments = more interest). IO loses value when rates fall. PO behaves like a regular bond: gains value when rates fall (faster principal return). IO is the counterintuitive one.
- PAC tranche protection: PAC is protected within a defined prepayment band. Companion tranche absorbs all excess prepayments above the band and shortfalls below. Companion = most prepayment risk. PAC = least.
- SPV (special purpose vehicle): Bankruptcy-remote legal entity that holds the loan pool. If the originator fails, SPV assets are protected from creditors. This structural separation is what enables the ABS credit rating.
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